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A 1031 real estate exchange is a method of selling a property and deferring capital gains taxes by buying replacement property, as specified in Section 1031 of the Internal Revenue Code. In other words, if you sell your property for a gain within one year before or after acquiring another property, you will be taxed on the gain from the sale of the first property at whatever tax rate applies to your income.
However, if you complete a 1031 exchange and hold that replacement property for at least one year after its purchase date, then any future gain from selling it would be taxed similarly to selling your primary residence. This is regardless of how many times you have exchanged properties over those years.
Therefore, understanding common myths associated with 1031 exchanges is essential, as they can save you significant tax expenses if properly handled.
The top common myths associated with 1031 exchanges are:
1) Replacing Debt With “Like-Kind” Debt
One of the most common myths is that you can only exchange property for like-kind debt. The truth is, Section 1031(a)(4) allows you to replace either equity or debt in your replacement property, depending on what you need at that time. The best way to approach this is to find a lender that will allow you to pay back your debt with other funds, such as cash.
2) Sale Funds Must Be Reinvested
Typically, you are not required to reinvest the sale funds into your replacement property. If you do want to invest in them, however, Section 1.1031(k)-1(A) of the IRS code allows you up to 180 days after the sale of the old property to buy replacement property without having to comply with a prompt-exchange rule.
3) Holding Period Requirement
If you have held your original property for more than one year before its sale and intend on treating it as a Section 1031 exchange, then you will have an extended holding period for your new investment. The total time that both properties are owned can be greater than one year but must not exceed two years for the 1031 exchange strategy to work for you.
4) Exchanges Are Not Available If You Sell Your Property for Less than Fair Market Value
This myth is very common among investors who don’t understand how Section 1031 works. However, the truth of the matter is that you may sell your property for less than fair market value and still be eligible to conduct a 1031 exchange so long as you follow all of the conditions and procedures outlined in the IRS code.
5) Replacement Properties Must Be Similar to Your Original Property
Another common myth is that nonequivalent properties cannot be used in a 1031 exchange. The truth is that if two properties are like-kind, they can qualify as replacement properties even if their character or quality differs from one another.
6) No Exchanges Are Allowed If You Sell Your Property for More than Its Replacement Cost
If you sell your property at a gain, you are not required to make an equal or similar amount of profit on the sale of your replacement property. This myth is commonly associated with properties that have recently rebounded in price, increasing their “replacement cost” beyond their sale price. The truth is that Section 1031 does not require you to replicate your original purchase price when buying a replacement property; it only requires that the properties be like-kind.
7) You Can’t Use Like-Kind Real Estate Exchange if You Are Purchasing Mixed-Use Property
Your real estate exchange can include both real and personal property so long they are both classified as like-kind, which means that they are depreciable over the same time frame and have similar useful lives. Therefore, you could purchase mixed-use property with your exchange funds so long as the different individual properties within the whole are considered to be of similar nature.
8) You Have to Use Exchange Funds for All Improvements
If you decide to use some of the money from your sale towards improving your replacement property, you do not need to limit yourself to using only proceeds from the sale of your original property. The truth is that while Section 1031 requires that any additional equity must come either from a cash or eligible debt instrument, it does not define how this equity can be used when making improvements on a replacement property.
9) You Can’t Hold More Than One Exchange at a Time
There is nothing in the IRS code that prohibits investors from conducting more than one 1031 exchange at a time. However, this does not mean that they can be conducted as simultaneous exchanges, which means you would have to complete each of them before starting another. Instead, you can proceed with all exchanges simultaneously until they close and still be compliant with Section 1031 regulations.
It’s important to know the myths and misconceptions about 1031 exchanges before you attempt one. The truth is that there are many conditions for a successful exchange, which means it can be easy to make mistakes or not follow IRS guidelines.
If you’re considering an exchange but aren’t sure if your situation qualifies, then contact our team of experts today! We’ll help walk you through every step to avoid missing out on any potential tax benefits.